Covenants and Collateral as Incentives to Monitor

ABSTRACT

Although monitoring borrowers is thought to be a major function of financial institutions, the presence of other claimants
reduces an institutional lender's incentives to do this. Thus loan contracts must be structured to enhance the lender's incentives
to monitor. Covenants make a loan's effective maturity, and the ability to collateralize makes a loan's effective priority,
contingent on monitoring by the lender. Thus both covenants and collateral can be motivated as contractual devices that increase
a lender's incentive to monitor. These results are consistent with a number of stylized facts about the use of covenants and
collateral in institutional lending.